Time Value of Money

Foundations of Finance
Lecture 2

The Time Value of Money:
An Introduction to Financial Mathematics

1. Lecture Overview
This week will provide you with an introduction to financial
mathematics. The lecture is designed to ensure you have the
tools necessary to calculate the value of financial
instruments later in the course. Todays lecture will
consider:
Why a dollar received today is worth more than a dollar received
any time after today; and,
How to calculate what a dollar received at some time in the
future is worth today.

Assumptions
No uncertainty
Perfect competition
No frictions
Capital flows relatively easily
Terminology
Single and multiple cash flows
PV=present value ($)
FV=future value ($)
n=# of periods (days (365), weeks (52),
fortnights (26), months (12), years)
r = interest rate (%; > 0)
Timeline

Time value of money: single cash flow
Example 1: Suppose a bank pays 10% p.a.
interest. You are given the choice between
two plans. Plan A, you receive $100 today.
Plan B, you receive $100 one year from now.

How can we compare these choices?
2.1 Future Value of a Single Cash Flow

Example 2: How much does $100 become after 2 years
earning an interest rate of 10%?

FV single cash flow: multiple periods
Year Future value
0 100 F
1 110 F(1+r)
2 121 F(1+r)(1+r)=F(1+r)
n
r F FV ) 1 ( + =
Solution Using Compound Interest Calculations:

Future Value = F
0
(1 + r)
n
FV = $100 (1 .1)
2
= $121

Solution:
This question is asking us to calculate the future value (ie the
worth of the asset at some future date). The answer to this
question depends on whether we use simple interest or
compound interest calculations:
Simple Interest: The amount of interest paid is only a function
of the initial principal invested (ie if the principal doesnt
change then, given a constant interest rate, the interest paid
each period will be the same); and,
Compound Interest: Interest in successive periods is calculated
based on the principal as well as on interest earned in previous
periods (ie interest is earned on interest).

Solution Using Simple Interest Calculations:
Future Value = Principal + interest
FV = F
0
+ F
0
r
s
n
= F
0
(1 + r
s
n)
= $100 (1 + [0.1*2])
= $120
Comparing the two answers, we can see the future value using
compound interest is $1 more than if we use simple interest.
Why? Because, with the compound interest, interest in the
second period included an amount earned on the interest we
were paid in the first period (ie in the second period, we earned
10% interest on the $10 interest from the first period, or an
extra $1).

Simple and compound interest
What is the value of $100 invested at 10%
compounded annually for 100 years?
Solution: 1, 378,061.234

What is the value of $100 invested at 10% p.a.
simple interest, for 100 years?
Solution: $1,100
From now on we will only use compound
interest

Future value: single cash flow
Example 3: Pat deposits $500 in the bank today.
What is the value of Pats investment after 10 years if
the investment earns 7% interest?

Future value: single cash flow
Example 4: Rebecca has $100,000 to invest and
she has narrowed down her decision to two
investments. Option A returns 60% p.a. for 4 years,
but the maximum investment she can make is
$10,000. Option B returns 12% p.a. for 4 years and
Rebecca can invest the whole $100,000. Which
option produces the best result for Rebecca and
what is the benefit over the lesser option? Assume
the $90,000 left from A is placed in a non interest
bearing bank deposit.

OPTION A: returns $155,536

OPTION B: returns $157,352
2.2 Present Value of a Single Cash Flow
Using the time value of money idea, we know that we would
have to put an amount less than $1 in the bank in order to
receive $1 from the investment in the future. Exactly how
much less than $1 we would need to deposit in the bank
initially depends on:

How long we are going to leave it there; and,
How much interest we will earn in the mean time.

Consider the following example.

Example 5:
What is the present value (PV) of receiving $110 1 year
from now if r = 10%?

PV requires looking back!

Solution Using Compound Interest Calculations:

Present Value = FV
(1 + r)
n

PV = 110
(1.10)

= $100

Present value: single cash flow
Example 6: Suppose you will inherit $200,000, 3 years
from now and r = 10%. What is the value to you today?

PV = FV

(1 + r)
n

=
200,000

(1.1)

= $150,262.9602

2.3 Future Value of Multiple Cash Flows
To calculate the future value of multiple cash
flows, we can simply employ the approach
discussed earlier. From this point, we will
discuss calculations using compound interest,
though it is important to note a simple interest
approach can also be employed.
Example:
You will make three bank deposits in the next 3 years, with the first
deposit to be made exactly 1 year from today. Further details of these
deposits are provided in the table below. Calculate the total value of
these deposits in exactly 3 years time given interest is paid at a rate of
10% per annum (calculated at the end of each year).
Time 1 year 2 years 3 years
Deposit
Amount
$100 $200 $500

Solution:
In answering this question, it is useful to draw a timeline:

We can see from the timeline that, in exactly 3 years time:
The first deposit ($100) will have been in the bank for exactly two years;
The second deposit ($200) will have been in the bank for exactly one year;
and,
The third deposit ($500) will be deposited in the bank immediately before
the time at which we wish calculate the total value of the deposits.
t=0 t=1 t=2 t=3
Deposit $100 Deposit $200 Deposit $500
We want to calculate the total
value of the 3 deposits here.
Solution:
Given this, we can calculate the total value of these deposits in
exactly three years time as follows:

FV
3
= $100(1.1)
2
+ $200(1.1) + $500
= $121 + $220 + $500
= $841
Now, lets say that the amounts we are to deposit are equal
in value. Lets say we plan to deposit $100 at the end of
each year for the next 3 years. A finite number of cash flows
that are equal in value and are evenly spaced are called
annuities. There are 3 types of annuities, which we will
now consider in turn:
Ordinary Annuities;
Annuities Due; and,
Deferred Annuities.
2.3.1 Future Value of Annuities
1) Ordinary Annuity
An ordinary annuity is one where the time between now and the
first cash flow is the same as the time separating each subsequent
cash flow. Diagrammatically, an ordinary annuity comprising n
cash flows of $F can be shown as:

An example of an ordinary annuity is the series of repayments
made on a bank loan.
$F $F $F $F $F
t=1 t=0 t=2 t=3 t=4 t=n ....
....
Future value of an ordinary annuity
Example: Peter deposits $100 at the end of
each year for 3 years at a rate of 10%. What is
the value of the annuity at the end of the 3
years?

1 2 3
Begin 0 100 210
Interest 0 10 21
Deposit 100 100 100
End 100 210 331
Future value of annuities
Year Cash flow Years to end Future value
0 0 3 0
1 F 2 F(1+r)
2 F 1 F(1+r)
3 F 0 F
To find the future value of an annuity comprising n
cash flows of $F immediately following the last cash
flow, we can either compound each individual cash
flow, or we can apply the formula below:

What about if there are an infinite number of cash
flows?

(1 ) 1
n
n r
r
FV F
r
FS
(
+
=
(

=
2) Annuity Due
An annuity due is one where the first cash flow occurs
immediately. However, the time between the first cash flow and
the second cash flow is the same as the time separating all
subsequent cash flows. Diagrammatically, an annuity due
comprising n cash flows of $F can be shown as:

An example of an annuity due is rent paid on a residential property.

$F $F $F $F $F $F
....
....
t=0 t=1 t=2 t=3 t=4 t=n-1
3) Deferred Annuity
A deferred annuity is one where the first cash flow occurs at some
time in the future, but the time between now and the first cash flow
does not equal the time separating each subsequent cash flow.
Diagrammatically, a deferred annuity comprising n cash flows of $F
that commences in m periods can be shown as:

An example of a deferred annuity is a buy now pay later scheme
often promoted by retail outlets.
$F $F $F $F
.... ....
....
.... t=0 t=m

t=m+1

t=m+2 t=m+n-1
Example:
Calculate the future value in 3 periods time of an ordinary
annuity comprising 3 payments of $500. These payments
are made at the end of each period, and the interest rate is
8% per period.

Solution:
Approach 1: Compounding each cash flow individually

Approach 2: Using the Future Value of an Annuity Formula

2
500(1.08) 500(1.08) 500
$1, 623.20
FV = + +
=
3
(1.08) 1
500
0.08
$1, 623.20
FV
(
=
(

=
Future value of ordinary annuity
Example: John is 40 years old and has
accumulated $100,000 in his retirement fund.
He can add $1200 at the end of each year to
the account which is returning 6%. Will he
have enough to retire on in 20 years, given he
estimates he needs $500,000?
2.4 Present Value of Multiple Cash Flows
When calculating the present value of multiple
cash flows, we can either:
Discount each cash flow individually and sum the
resultant values to calculate the present value; or,
In the cash of identical evenly spaced cash flows,
we can use the present value of an annuity
formula.
Example
I expect to receive the following cash flows over the next four
years.

What is the present value of these cash flows given they are
received at the end of the relevant year and the interest rate is 10%
p.a?

Time 1 year 2 years 3 years 4 years
Cash Flow $300 $290 $500 $580
Solution
While the cash flows are evenly spaced, they are not of the same
dollar value. Therefore, they are not an annuity and, in order to
calculate their present value, we must discount them individually
before summing them.

2 3 4
300 290 500 580
(1.10) (1.10) (1.10) (1.10)
$1, 284.20
PV = + + +
=
2.4.1 Present Value of Annuities
The formula used to calculate the present value
of an annuity differs based on the type of annuity
being considered. Lets consider each type of
annuity in turn.
1) Ordinary Annuity
Recall that an ordinary annuity is one where the time between
now and the first cash flow is the same as the time separating each
subsequent cash flow. To calculate the present value of an
ordinary annuity comprising n cash flows of $F, we use the
following equation:

2
...........
(1 ) (1 ) (1 )
1 (1 )
n
n
n r
F F F
PV
r r r
r
F
r
FA
= + + +
+ + +
( +
=
(

=
Ordinary Annuity Example
The present value of an ordinary annuity comprising 10 annual cash
flows of $500 each is calculated as follows given an interest rate of
10% p.a. :

10
1 (1 )
1 (1.10)
500
0.10
$3, 072.28
n
r
PV F
r
( +
=
(

(
=
(

=
2) Annuity Due
Recall that an annuity due is one where the first cash flow occurs
immediately. To calculate the present value of an annuity due
comprising n cash flows of $F, we use the following equation:

2 1
( 1)
1
...........
(1 ) (1 ) (1 )
1 (1 )
n
n
n r
F F F
PV F
r r r
r
F F
r
F FA
= + + + +
+ + +
( +
= +
(

= +
Annuity Due Example
The present value of an annuity due comprising 10 annual cash flows of $500
each is calculated as follows given an interest rate of 10% p.a.

When we compare this with the present value of the ordinary annuity from
Slide 29, we see the present value of the annuity due is higher. Why?
( 1)
9
1 (1 )
1 (1.10)
500 500
0.10
$3, 379.51
n
r
PV F F
r

( +
= +
(

(
= +
(

=
The reason:
payments made under an ordinary annuity occur at the end of
the period while payments made under an annuity due occur
at the beginning of the period.
The PV is larger under the annuity due because all the
payments are made earlier. In other words, they are all closer
to the "present" so they are subject to less discounting.
3) Deferred Annuity
Recall that a deferred annuity is simply an annuity that
commences as some time in the future. To calculate the present
value of a deferred annuity that commences in m periods and
comprises n cash flows of $F, we use the following:

1
1 (1 )
(1 )
n
m
r
F
r
PV
r
( +
(

=
+
Deferred Annuity Example
The present value of a deferred annuity commencing in 5 years
that comprises 10 annual cash flows of $500 each is calculated as
follows given an interest rate of 10% p.a. :

What about if there are an infinite number of cash flows?

10
4
1 (1.10)
500
0.10
(1.10)
$2, 098.41
PV
(
(

=
=
2.4.2 Present Value of Perpetuities
A perpetuity is a series of equally spaced cash flows of same dollar
value that continues on forever. As with annuities, perpetuities
can be broken into three types based on the time until the first
cash flow occurs, namely:
Ordinary Perpetuities;
Perpetuities Due; and,
Deferred Perpetuities.

1) Ordinary Perpetuity
Ordinary Perpetuity: The time between now and the first cash flow
is the same as the time separating subsequent cash flows. The
only difference between an ordinary perpetuity and an ordinary
annuity is that, in the case of the ordinary perpetuity, cash flows
continue forever. The present value of an ordinary perpetuity
comprising individual cash flows of $F is calculated as:

F
PV
r
=
Ordinary Perpetuity Example
The present value of an ordinary perpetuity that comprises annual
cash flows of $500 each is calculated as follows given an interest
rate of 10% p.a.:

500
0.1
$5, 000
PV =
=
Example: At what interest rate would you be
indifferent to a perpetuity paying 2,000,000
p.a. and a one off payment of 40,000,000?

Solution:
At a 5% interest rate you are indifferent. If the
interest rate is above 5% the immediate
onetime payment is better; because future
cash flows are less valuable. If the r is below
5%, the perpetuity payment is better, because
future cash flows are more valuable.

2) Perpetuity Due
Perpetuity Due: The first cash flow occurs immediately. The only
difference between a perpetuity due and an annuity due is that, in
the case of the perpetuity due, cash flows continue forever. The
present value of an annuity due comprising individual cash flows of
$F is calculated as:

F
PV F
r
= +
Perpetuity Due Example
The present value of a perpetuity due that comprises annual cash
flows of $500 each is calculated as follows given an interest rate of
10% p.a.:

500
500
0.1
$5, 500
F
PV F
r
= +
= +
=
3) Deferred Perpetuity
Deferred Perpetuity: A perpetuity that commences some time in the
future, but the time between now and the first cash flow does not
equal the time separating each subsequent cash flow. The only
difference between a deferred perpetuity and a deferred annuity is
that, in the case of the deferred perpetuity, cash flows continue
forever. The present value of a deferred annuity commencing in m
periods and comprising individual cash flows of $F is calculated as:

1
(1 )
m
F
r
PV
r

(
(

=
+
Deferred Perpetuity Example
The present value of a deferred perpetuity that commences in 4 years
and comprises annual cash flows of $500 each is calculated as follows
given an interest rate of 10% p.a.:

1
3
(1 )
500
0.1
(1.10)
$3, 756, 57
m
F
r
PV
r

=
+
=
=
3. Interest Rates for Time Value of Money
Calculations
In time value of money calculations, it is very important to ensure
that each piece of information included in calculations is expressed in
terms of the time frame. Consider the following examples.

Example 1:
When calculating the present value of a single cash flow, if the
number of periods (n) is expressed in terms of the number of years till
the cash flow is received, then the interest rate (r) used must also be
expressed as a rate applied once a year. In the case of a single cash
flow, n and r could also be expressed as semi-annual figures, etc and
the answer would be the same.

Calculations
Example 2:
When calculating the present value of an annuity / perpetuity,
both n and r must be expressed in terms of the same time as the
period between each cash flow. So, if cash flows are monthly, n
should represent the number of months and r should be the
monthly interest rate.

We already know how to convert n from the number of years to
the number of months, but how do you convert r from an annual
rate to a monthly rate? Use the Interest Rate Wheel. Before we
look at the wheel, lets familiarize ourselves with some interest
rate terminology.
Calculations
First, consider the difference between annual effective, annual nominal and
periodic interest rates:
Annual effective interest rate: An interest rate where the frequency of
charging / payment matches the period specified by the interest rate. In other
words, the rate is quoted annually and is applied annually;
Annual nominal interest rate: An interest rate where interest is charged more
frequently than the time period specified in the interest rate. For example,
12% p.a. compounded monthly is an example of a nominal interest rate; and,
Periodic interest rate: The rate of interest applied per compound period in the
case of a nominal interest rate. For example, if the interest rate is 12%
compounded semi-annually, the periodic (6 month) interest rate is 12%/2 =
6%.

Calculations
How do we know which rate to use?
Recall the earlier discussion on using information in the
equations that is expressed in terms of the same time
frame. More specifically:
Use an annual effective rate to calculate future or present
value when:
You have an annuity / perpetuity with annual cash flows. Here,
you must also have n expressed in terms of number of years; or,
You have multiple uneven cash flows / a single cash flow and
you have expressed n in terms of the number of years.

Calculations
Use a periodic interest rate to calculate future or present value
when:
You have an annuity / perpetuity with cash flows paid less than
annually. Here, the periodic rate must be expressed as frequently
as the cash flows. For example:
If you have an annuity paid monthly, you must use a monthly
periodic interest rate and a monthly value of n; and,
If you have an annuity paid quarterly, you must use a quarterly
period interest rate and a quarterly value of n.
You have multiple uneven cash flows / a single cash flow and you
want to use a value of n calculated based on the same period as the
period rate. For example;
If you have n expressed in terms of months, use a monthly period
rate; and,
If you have n expressed in terms of days, use a daily periodic rate.
NB: It doesnt matter what period you use, as long as r and n are
both calculated based on this period.

3. Interest Rates for Time Value of Money Calculations
I In nt te er re es st t R Ra at te e W Wh he ee el l

Annual Effective Rate

(1 ) 1
n
e p
r r = +
1/
(1 ) 1
n
p e
r r = +

Periodic Rate (1 ) 1
n n
e
r
r
n
= +
1/
[(1 ) 1]
n
n e
r n r = + Periodic Rate

n
p
r
r
n
=
n p
r r n =

Annual Nominal Rate

Where: r
e
= annual effective rate
r
n
= nominal annual rate
r
p
= periodic rate (eg monthly, quarterly, etc)
n = number of compounding periods per annum
Calculations
Examples
Calculate the annual effective interest rate given an interest rate
of 12% p.a. compounded quarterly.

4
(1 ) 1
0.12
(1 ) 1
4
0.1255
12.55% . .
n
n
e
r
r
n
p a
= +
= +
=
=
Calculations
Examples (Continued)
3. Calculate the monthly periodic interest rate given an interest rate of
9% p.a compounded monthly.

0.09
12
0.0075
0.75%
n
p
r
r
n
=
=
=
=
Calculations
Calculate the 6 month interest rate (semi-annually, which is a
periodic interest rate) given an interest rate of 10% p.a.
compounded annually.

1/
1/ 2
(1 ) 1
(1.10) 1
0.0488
4.88%
n
p e
r r = +
=
=
=
Calculations
Calculate the monthly periodic interest rate given an interest rate of
12% p.a. compounded quarterly.

Step1: to find the annual effective interest rate

4
(1 ) 1
0.12
(1 ) 1
4
0.1255
12.55% . .
n
n
e
r
r
n
p a
= +
= +
=
=
Calculations

Step 2: To calculate the monthly periodic interest rate given the
annual effective interest rate is 12.55%.
In answering questions ask yourself
Single or multiple cash flow?
PV or FV?
Is time period between cash flows
same/different to quoted time period of
interest compounding?
Examples
1. Calculate the future value of $1000 invested
today for a period of 20 years at an interest
rate of 10% compounded daily? How and
why would your answer differ if interest was
compounded quarterly?
Solution A:
Single cash flow
FV
n = 20 x 365
r = .10/365
FV = 1,000

= $7,387.03
365 20
)
365
10 . 0
1 (
x
+
Solution B: interest is compounded quarterly
FV = 1,000
= $7,209.57

The value is less because there is less
compounding.
4 20
)
4
10 . 0
1 (
x
+
Example:
What is the PV of a perpetuity paying
$15/month, beginning next month, if the
effective annual interest rate is a constant
12.68% p.a.?

Solution:
Step 1: convert annual effective interest rate
to a periodic rate (use interest rate wheel)

= about 1%
Step 2: Apply PV of perpetuity formula
PV = 15/.01= $1500

1 ) 1 (
/ 1
+ =
n
e p
r r
Jordan has successfully applied for a home
loan. Calculate how much he is borrowing
given the terms of the loan are as follows:
Monthly repayments are $1,000
The loan is taken over 25 years
The interest rate is fixed at 10% p.a. compounded
quarterly
Solution:
We need to calculate the PV of all the repayments to work out how much will
be borrowed. The payments are evenly spaced and equal amounts so use
ordinary annuity formula. But cash flows occur at a different interval to
the interest compounding.

Step 1: calculate (0.103812)

Step 2: calculate monthly rate: (0.008264)

Step 3: use PV of annuity formula; n = 12 x 25

Answer: $ 110, 752.65
e
r
p
r
Next Week.
Next week we will apply the financial
mathematics we have learnt in todays lecture to
valuing shares in a company.

Time Value of Money

Transféré par

Informations du document

Titre original

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

Time Value of Money

Transféré par

Droits d'auteur :

Formats disponibles

Foundations of Finance

Vous aimerez peut-être aussi